55 PagesPosted: 20 Jul 2022
Date Written: July 8, 2022
Abstract
In four well-powered experiments (N=1,195), I study an application of the affect heuristic to the evaluation of financial assets. The affect heuristic predicts that people derive expectations of return and risk from a global affective impression of an asset, which leads to negative risk-return correlations. Experimental results confirm the presence of an affect heuristic when evaluating individual stocks. Negative risk-return correlations emerge for aggregated results, as well as within individuals. However, a positive correlation found for asset classes suggests that the ease to recognize a risk-return trade-off can curb the reliance on the affect heuristic. Asking for required returns instead of expected returns also makes the risk-return trade-off more salient. Allowing people to select their most liked or disliked stocks, in contrast, exacerbates the use of the affect heuristic as participants presumably select stocks they feel most strongly about. In an extension, I show how the affect heuristic is used in evaluating ESG performance.
Keywords: Affect heuristic, dual process theory, return expectations, risk perception, correlation, risk-return trade-off, ESG, sustainability.
JEL Classification: G11, G23, G41, O33
Suggested Citation:Suggested Citation
FAQs
The influence of the affect heuristic can be seen in various aspects of life. For example, in the realm of investments, a person might choose stocks based not on a thorough analysis of the company's financial health but on positive feelings about the brand.
What is the ESG risk and opportunity assessment? ›
ESG Risk and opportunity identification
Assessing relevant factors that are crucial for Industry and businesses. We identify all the risk associated with the climate, environment, supply chain of the company and the potential financial risk associated with the investments.
What is an example of heuristic in finance? ›
Such mental shortcuts allow us to make decisions quickly, but they can also be inaccurate. One example of the availability heuristic is stock prices, especially for newly public companies. Many investors tend to invest in new IPOs in the hopes that the stock price will increase significantly in the next few years.
What is a heuristic approach in finance? ›
Heuristics simplify the decision-making process, which means they simplify the financial decision making process, as well. Without them, you'd have to spend much more time making decisions. However, relying on heuristics without carefully analyzing investment options can lead to irrational or incorrect decisions.
What is the ESG risk assessment process? ›
To conduct an ESG risk assessment, define your assessment scope and criteria. Identify environmental, social, and governance risks through data from internal operations and external industry sources. Analyze the likelihood and impact of these risks, integrating findings into company strategy.
What is the ESG risk assessment methodology? ›
The ESG risk assessment methodology is based on IFC Performance Standards, the World Bank EHS Guidelines, EBRD risk classifications and other industry best practices. Provides insights on a portfolio's environmental and social (E&S) risk exposure.
What are the five risk levels of ESG ratings? ›
The ESG Risk Ratings are categorized across five risk levels: negligible (0-10), low (10-20), medium (20-30), high (30-40) and severe (40+).
What is the affect heuristic in business? ›
The affect heuristic occurs when our current emotional state or mood influences our decisions. Instead of evaluating the situation objectively, we rely on our “gut feelings” and respond according to how we feel. As a result, the affect heuristic can lead to suboptimal decision-making.
What is the heuristic theory of financial literacy? ›
Heuristic theory explains how investors make financial decisions under conditions of uncertainty. According to this theory, there are a lot of bias beliefs that affect how investors think and making decisions, while the prospect theory explains how investors make decisions under a certain risk.
What are heuristics in investing? ›
Heuristics suggest investors use rules of thumb to reduce the complexity of the decision-making process (Ricciardi and Simon, 2001). Tversky and Kahneman (1974) introduced representativeness heuristic, in which individuals cling to results that are more representative of the evidence.
For example, people use past performance as the best predictor for future performance and often invest in the mutual funds with the best five-year track records. These rules are likely to be faulty and generally lead to poor decisions. Relying on such heuristics is called 'Heuristic Bias'.
